From bad to ugly, it's not looking good for Chinese firms

The earnings season just starting will reveal a lot about business conditions in China. It could get ugly.

Profit margins at many Chinese companies have been getting squeezed for a year or more. Reckless over-investment in new plants, fuelled by cheap bank credit, has boosted manufacturing capacity in sectors from cars through fridges to mobile phones.

That has generated massive demand for raw materials, pushing input prices sharply higher. At the same time, the sheer profusion of companies in each sector has bred fierce competition, preventing manufacturers from passing their higher costs on to consumers.

As a result, profit margins have been shrinking. According to credit rating agency Standard & Poor's (S&P), median operating margins at Chinese manufacturers of home appliances shrank to just 2.3 per cent last year, down from an already thin 5.9 per cent in 2002. Margins at technology companies and carmakers were not much better, at 5.4 per cent and 7.9 per cent, respectively.

Even those figures understate the true magnitude of the problem. In compiling its data, S&P examined only the cream of corporate China: the top 100 listed companies by revenues. 'There are a lot more companies underneath which are finding conditions a lot more difficult,' said S&P managing director John Bailey.

The environment has deteriorated further this year. The past couple of months have seen a spate of profit warnings from leading Chinese companies. Last week, the National Development and Reform Commission said red ink at money-losing companies had risen to 107.5 billion yuan during the first half, nearly 60 per cent more than for the same period last year. The worst offenders were state-owned enterprises, where losses rose 84 per cent.